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The Impact of Regulatory News and Discount Rate Changes on the Time Varying Volatility of Interest Rate Swap Spreads

The explosive growth of the interest rate swap market (as well as the entire derivative market) has drawn regulatory concern. Among the reasons for concern is the belief that the interest rate swap is a risky interest rate management tool. The exposure created by the use of an interest rate swap is a function of unexpected changes in interest rates, regulatory, legal, and accounting documentation. Prior studies that addressed the risk of interest rate swaps have focused on the actual and potential risk of default ensuing from these unexpected changes. While the loss from default is arguably the most important exposure created by the use of interest rate swaps, understanding swap price movements in different market environments facilitates the efficient management of interest rate swap positions, and could therefore reduce the riskiness of this interest rate risk management tool. This study conducts an empirical analysis of the impact of regulatory news and discount rate changes on the time varying volatility of interest rate swap spreads across various maturities.